Price Leadership- Meaning, Types and Price-Output Determination Under Low cost Price Leadership and Domanant Firm Price Leadership

Price Leadership: Price leadership is an important form of collusive oligopoly. It   takes place when there is only one dominant firm in the industry, which sets the price and others follow it. Sometimes, an agreement may be developed among oligopoly firms of an industry to assign a leadership role to one of them. There is a tacit or formal agreement among the firms to sell the product at a price set by the leader- firm of the industry. If the products are homogeneous, a uniform price is set. In case of differentiated products also prices can be uniform. If there is any change in price, the leader-firm announces from time to time, and the other firms follow him.  Price leadership works effectively when the products are homogeneous and all the firms  have identical cost curves.

There are various types of price leadership.

1. There is the barometric  price leadership in which there is no leader-firm but an experienced, and largest firm assumes the role of a custodian who protects the interests of all. He assesses the market conditions with regard to the demand for the product, cost of production, competition from the related products etc. and sets a price which is best for all the firms in the industry. This barometric firm only initiates a reaction to changing market situation, which other firms may follow it if they find these reaction in their interest.

2. There is the dominant price leadership where one big firm, the largest in the industry, dominates the market like a monopolist. This dominant firm wields a great influence over the market for the product, while other firms are small and are incapable of making any impact on the market. As a result, the dominant firm estimates its own demand curve and fixes a price which maximizes its own profits. The other firms which are small having no individual effects on the price of the product, follow the dominant firm and accept the price set by it and adjust their output accordingly. Dominant price leadership is sometimes termed-as partial monopoly as the interests of other firms are ignored by the dominant firm. This type of price leadership is most commonly seen in the industry.

3. There is the aggressive or exploitative price leadership in which a dominant firm establishes leadership by following aggressive price policies by fixing the profit maximization price for itself and compels other firms to follow the prices set by it. Such a firm will often initiate a move threatening to compete the others out of market if they do not follow it in setting their prices.

4. There is a low-cost firm price leadership where the low-cost firm sets a lower price than the profit-maximizing price of the high-cost firms. Thus, the high-cost firms are forced to agree to the lower price set by the low-cost firm. The low-cost price leader has to ensure that the price which he sets must yield some profits to the high-cost firms too.

Price-Output Determination under Low-Cost Price Leadership:

An oligopolistic firm having lower costs than the other firms is in a position to set a lower price which the other firms have to follow, and becomes the price leader. There are following assumptions which make the analysis very simple:

(i)- There are two firms, A and B. The firm A has a lower cost of production than firm B.

(ii)- The product produced by both firms is homogeneous so that the consumers have no preference between them.

(iii)-Each of the two firms has equal share in the market. That’s why demand curve facing each firm will be the same and will be half of the total market demand curve of product.

Each firm is facing demand curve df [it is representing the market MR curve also] which is half of the total market demand curve DD for the product. MR is the marginal revenue curve of each firm. ACa and MCa are the average and marginal cost curves of firm A, and ACb and MCb are the average and marginal cost curves of firm B. Cost curves of firm A lie below the cost curves of firm B as firm A has a lower cost of production than firm B. The firm A is in equilibrium at point E where  its marginal cost is equal to the marginal revenue and will maximize its profits by selling output OM at price OP. Firm B’s profits will be maximum when it fixes price OH and sells output ON as its MCb and MR intersects each other at point F. From the diagram it is clear that profit-maximizing price OP of firm A is lower than the profit-maximizing price OH of firm B. Since the two firms sell a homogeneous product, they cannot charge two different prices. Because the price OP of firm A is lower than the price OH of firm B, firm A will emerge as a price leader and firm B will be compelled to follow.

Firm B after having accepted firm A as the price leader will actually charge price OP and it will also sell OM because both the firm share the half market and the demand curve facing each firm is the same. Thus, both the firms will charge the same price OP and sell the same amount (OM). The total output of the two firms will be OM + OM = OQ which will be equal to the market demand at price OP. At OP price firm A, the price leader, will maximize its profits  as it is lower cost firm while the firm B will not be making maximum profits with this price-output combination and it will be smaller than firm A because its costs are greater than firm A.

Price-Output Determination Under Price Leadership by the Dominant Firm:

When there is one large dominant firm and a number of small firms in the industry. The dominant firm fixes the price for the entire industry and the small firms sell the product  at the price set by dominant firm. It will select that price which brings more profits to itself. This model is based on the following assumptions:

  • The dominant firm has complete control over the market price.
  • All other firms act like perfect competitors. Their demand curves are perfectly elastic for they sell the product at the dominant firm’s price.
  • The dominant firm alone is capable of estimating the market demand curve for the product.
  • The dominant firm is in a position to predict the supplies of other firms at each price set by it.

Since each firm sells its product at the price set by the dominant firm, its demand curve is perfectly elastic at that price. we assume that the dominant firm knows the total market demand curve for the product and also knows the marginal cost curves of the smaller firms whose lateral summation yields the total supply of the product by the small firms at various prices. This implies that from its past experience the dominant firm can estimate the likely supply of the product by the small firms at various prices. With this information, the leader can obtain his demand curve.

In the diagram, in panel (A) DD is the market demand curve for the product and Sm is the supply curve the product of all the small firms taken together. At each price the leader will be able to sell the part of the market demand not fulfilled by the supply from the small firms. Thus, at price P1, the small firms supply the whole of the quantity of the product demanded at that price. Therefore, demand for leader’s product is zero. At price P2, the small firms supply P2C and therefore the remaining part of CT of the market demand will constitute the demand for the leader’s product. The demand for leader’s product has been separately shown in panel (b) by the DL curve. P2Z in panel (b) is equal to C T in panel (a). At price P3, the supply of the product by the small firms is zero. Therefore, the whole market demand SU will have to be satisfied by the price leader. Likewise, the other point of the demand curve for the price leader can be obtained. In panel (b) the MRL is the marginal revenue curve of the price leader corresponding to his demand curve dL. AC and MC are his average and marginal cost curves. The dominant price leader will maximize his profits by producing output OQ and setting price OP [or HQ]. The followers, that is, the small firms will charge the price OP and will together produce PB. [PH in panel (b) equals BS1 of panel (a).

Price leadership involves many difficulties in the real world. First, sometimes his estimates proves to be incorrect about the reactions of his rivals to price changes and it creates difficulty in the success of leadership. Second, when a price leader fixes a higher price than the followers would prefer, then it will induce the rivals to make secret price cuts by increasing number of concessions and discounts which will adversely affect the sales of the price leader.

Third, the rivals charge the same price set by the leader but try to increase their share of the market by increasing the advertisement expenditure, as a result,  the price leader has also to indulge in non- price competition to prevent the fall in its sales and  may not be able to maintain his leadership for a long time.

Further, there is another limitation for the price leader to fix a high price of his product. Sometimes, a high price fixed by the price leader will attract new competitors into the industry which may not accept his leadership

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